financial statement analysis and business valuation

Tim Miller, CLU, FALU, FLMIMunich American Reassurance

Financial Statement Analysis and Business Valuation

Financial Analysis Overview

Perspective on U.S. Business

In 2002 total receipts for all

U.S. firms was 22.8 trillion

dollars.

Of that amount only 770 billion

dollars was generated by non-

employer firms.

Employer firms made up about

24% of all firms and accounted

for over 96% of all receipts.

*U.S. Census Bureau

Perspective on U.S. Business

According to the U.S.

Census Bureau in 2004

there were a total of

25,409,525 businesses.

Of that number 5,885,784

were classified as employer

firms ( having a payroll ).

Firms with 100 or more

employees numbered only

123,983.

Perspective on U.S. Business

In 2004 about three quarters

of all U.S. business firms had

no payroll.

They are called non-employer

firms. There were a total of

19,523,741 firms.

They only accounted for

about 3.4 percent of business

receipts, which was over 887

billion dollars.

These firms are not included

in most business statistics.

Financial Statement AnalysisBalance Sheet

Assets

Current Assets:

• Cash and cash equivalents

• Investments

• Accounts receivable net of allowance for doubtful accounts

• Inventories

Long-term Assets

• Equipment

• Land and Building

• less accumulated depreciation

Financial Statement Analysis

Other assets

• Long-term investments

• Goodwill and other intangible assets

Total Assets

Liabilities

Current Liabilities

• Notes payable

• Accounts payable

• Interest ( current portion )

• Taxes payable

Long-term Liabilities

• Long-term debt

Financial Statement Analysis

• Bonds payable

• Notes payable

Total Liabilities

Stockholder’s Equity

• Common stock

• Retained earnings

Total Liabilities and Stockholder’s Equity

Total Assets = Total Liabilities + Stockholder’s Equity

Financial Statement Analysis

Income Statement

Sales / Revenues

minus Cost of Sales / Revenues ( a.k.a. COGS ) =

Gross Profit

minus Operating Expenses =

Operating Income

plus/minus non-operating expenses/income =

Total Income

Minus income taxes =

Net income

Financial Statement AnalysisLiquidity Ratios

Current Ratio

Current Assets

Current Liabilities

•Measure of ability to meet current obligations•A ratio of 2:1 or higher is considered sufficient, a number less than 2 is suspect•some businesses with a longer inventory turnover or longer receivables turnover may have lower current ratios and be considered stable

Financial Statement AnalysisLiquidity Ratios

Quick Ratio

Cash and Cash Equivalents

Current Liabilities

•The quick ratio is an indication of the ability of a company to quickly convert assets to cash to meet obligations in the event of an emergency. •A quick ratio of 1:1 is considered adequate.

Financial Statement AnalysisDebt Utilization Ratios

Debt Utilization Ratios – these ratios measure the extent to which a business uses debt to finance operations. In general the higher the proportion of debt the riskier the capital structure.

Financial Statement AnalysisDebt Ratios

Debt Ratio

Total Debt

Total Assets

•This ratio looks at the relationship between total assets and total debt•The amount of debt used to finance total assets. •A measure of how efficient an organization has used leverage.• A ratio of 1:2 is considered reasonable.

Financial Statement AnalysisDebt Ratios

Debt to

Equity Ratio

Total Debt

Net Worth

•This ratio looks at the relationship between debt and owner’s equity or stockholder’s •It is a measure of the riskiness of a company’s capital structure. •The higher the proportion of debt the greater the risk to creditors. •Investors would also be at even greater risk in the event of bankruptcy because the creditors claim will be satisfied before investors can recover.

Financial Statement Analysis

Times Interest

Earned

Operating Profit

Interest Expense

•measures the ability of a company to pay interest expense associated with debt from operating profits•higher the number the better

Financial Statement AnalysisProfitability Ratios

Financial Statement AnalysisReturn on Equity

•Rate of return relative to equity invested in business•Determines if business is making enough profit to warrant business risk

Financial Statement AnalysisOperating Profit Margin

OPM

Operating Profit

Net Sales

•Measure profit per percentage of each sales dollar•Higher percentage more effective converting revenues to profit•Useful comparing

Financial Statement AnalysisReturn on Assets

ROA

Net Earnings

Total Assets

•Also known as Return on Investment (ROI)•Indicates profitability relative to total assets•Measures effectiveness in business use of assets to generate after-tax profits

Financial Statement Analysis

Read the notes attached to the statements:

Business Valuation

Business ValuationBook Value

Business ValuationAdjusted Book Value

Business ValuationAdjusted Book Value

Business ValuationCapitalization of Earnings

A valuation technique under the income approach where a

single representative period is used to determine a value for a

business through application of a capitalization rate. This

expressed as:

Value

Income

Rate

Business Valuation

Determining a reasonable figure for business income is key. Sometimes referred to as Owner’s Discretionary Income.

Business Valuation

Business ValuationCapitalization of Earnings

Capitalization Rate – Business Type / Perceived Risk

RISK

RISK

Business Valuation

Several models have been developed to classify businesses

into groups based on business characteristics with risk levels

assigned. The following model was authored by Arthur Stone

Dewing ( The Financial Policy of Corporations, 5th Edition, The

Ronald Press, 1953 ) and is a good general guide that can be

used for valuation purposes.

Business Valuation

Category Capitalization Rate Multiple

Old established business with significant hard assets and excellent goodwill

10% 10

Well- established business requiring considerable managerial care

12.5% 8

Strong, well developed businesses susceptible to general economic swings and requiring considerable managerial care

15% 7

Highly competitive businesses with low levels of hard assets requiring average levels of managerial care

20% 5

Business Valuation

Category Capitalization Rate Multiple

Small, highly competitive businesses requiring little capital investment

25% 4

Large or small businesses requiring special managerial skills of one or more persons with little capital investment and in highly competitive fields where failure is a strong possibility

50% 2

Personal service businesses whose success reflects the skill of the manager

100% 1

Business Valuation

Case Sample - Capitalization of Earnings

A sole proprietor owns a small printing operation. The business

is well established with stable earnings and a good

competitive position in the market. The company has a net

income of $100,000. This company may be considered

appropriate for category three and a 15% capitalization rate,

or a multiple of 7. An approximate value would be $700,000.

Business Valuation Discounted Future Earnings

Business Valuation Discounted Future Earnings

RISK

RISKEarnings Unpredictable,Highly Competitive Market,Questionable Competitive Position, Managerial Questions

Business Valuation

The discount rate used is reflective of the amount of risk for the particular

business in question. That is, the amount of uncertainty around realizing

the expected future earnings stream. The greater the perceived risk, the

higher the discount rate and the lower the valuation for the business.  

As with the Capitalization of Earnings Method there are several models

that have been developed. One such methodology was authored by

James H. Schilt ( “ A Rational Approach to Capitalization Rates for

Discounting the Future Income Stream of Closely Held Companies,” The

Financial Planner, January 1982 ) and offers five categories with

recommended discount rates. These rates are added to a risk-free rate,

such as that paid by U.S. Treasuries.

Business Valuation

Category Discount Rate

#1 – Established businesses, good trade position, good management, stable past earnings, predictable future

6 – 10%

#2 – Same as #1 except in more competitive industries

11 – 15%

#3 – Companies in highly competitive industries, with little capital investment and no management depth, although with good historical earnings record

16 – 20%

#4 – Small businesses that depend on the skill of one or two people, or large companies in highly cyclical industries with very low predictability

21 – 15%

#5 – Small personal service businesses with a single owner/manager 26 – 30%

Business Valuation

Year Cash Flow Discount Factor 10%

Present Value

1 $100,000 0.9091 $90,910

2 $103,000 0.8264 $85,119

3 $106,090 0.7513 $79,705

4 $109,270 0.6830 $74,631

5 $112,550 0.6209 $69,882

6 $115,930 0.5645 $65,442

7 $119,410 0.5132 $61,281

8 $122,990 0.4665 $57,333

9 $126,680 0.4241 $53,725

10 $130,480 0.3855 $50,300

Total $1,146,400 Total $688,328

Business Valuation

In this example we have a company with projected revenues of

$1,146,400 over the next 10 years. Using a discount rate of

10% applied to each of the ten years a total figure of

$688,328 is calculated. This is amount represents the value of

that revenue stream today to a potential buyer given the

assumptions made. A business with a perceived higher risk

would be given a higher discount rate and the value

calculated would be increasingly smaller as the discount rate

increased. For example, a discount rate of 15% would total

$556,482.

Business ValuationValuing Professional Practices

Business ValuationValuing Professional Practices

Goodwill is defined in the valuation industry as: “that intangible

asset arising as a result of name, reputation, customer loyalty,

location, products, and similar factors not separately identified.”*

Business ValuationGoodwill

Goodwill can be divided into two forms:

Business ValuationFactors Affecting Value

*Financial Valuation: Applications and Models, James Hitchner

Business ValuationCash Basis Accounting

In professional practices cash-basis accounting is often used.

This may make some financial statement adjustments

necessary to value the business.

Historical Perspective on Valuation

Based on historical prices for businesses sold, it was noted the multiple of

owner’s discretionary income ( ODI ) increased with the amount of ODI.

ODI Multiple

< $100,000 1.2 – 2.4

$100,000 to $250,000 2.0 – 3.2

>$250,000 to $500,000 2.5 – 3.6

>$500,000 to $1,000,000 2.5 – 4.2

Over $1,000,000 EBITDA was used

3.5 – 5.5

$2,000,000 5 +

*www.choicebizops.com/SDE_multiple.htm

Historical Perspective

Favorable factors that supported using a multiple higher in the range included:

Historical Perspective

*www.choicebizops.com/SDE_multiple.htm

ResourcesWeb Sites

www.sba.gov

www.investopedia.com

www.irs.gov

www.sec.gov

www.bls.gov

www.census.gov

www.stat-usa.gov

www.bizterms.net

www.bloomberg.com

www.nasdaq.com

www.nyse.com

www.bizcomps.com (pay)

www.bizminer.com (pay)

www.valuationrresources.com (pay)

www.commerce.gov

Thank you!